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The recent increases in the real estate market has sent more and more first time real estate investors to Drive Planning. One of the common questions that we receive is centered around purchasing real estate (either to flip or rental/buy and hold) inside of a Qualified Retirement Plan, such as an Individual Retirement Account (IRA) or other types of plans.
This is most common for those who do not have funds which are outside of their Retirement Plan. So, a better question is, Where else can I get funding for my real estate deal? There are numerous sources for funds if you know where to look, regardless of credit!
Let’s Take a Look at The Problem
For the remainder of this blog I want to focus on why purchasing real estate inside of an IRA is a poor idea.
An IRA is a tax shelter. Tax on the income is either deferred (Traditional IRA) or eliminated entirely (Roth IRA).
Rental real estate is an example of a type of real estate investment that can be a tax shelter on its own. Rental real estate often generates losses for tax purposes even when there is positive cash flow. This is because of the depreciation deduction that can be taken on the investment.
With proper tax and accounting, rental losses can be used to offset other income which effectively shelters that other income from income tax. This can result in significant tax savings.
If an IRA has rental losses, the IRA is generally not paying tax so there is no tax to shelter.
If an individual has rental losses, there is an opportunity to shelter other income, including W-2 or business income, from income tax. This results in not paying tax on that other income and those tax savings mean cash in your pocket.
Lastly, in retirement any proceeds from real estate inside of an IRA (Traditional) comes out as ordinary income!
In addition, these problems also come along with Real Estate purchased within an IRA/Qualified Plan:
- Lose 1031 Tax Free Exchanges
- Lose “Step Up in Basis” at Death
- No Capital Gains Tax Rates
- Potential Increase in Tax Rates
- Lose enjoyment/use of funds prior to age 59 1/2 (Proposed/Potentially to be age 70 1/2 in the future)
The Bottom Line
Our team at Drive Planning has over 250 years of experience with situations like we’ve described above; therefore we believe that the tax savings are too significant so the property should be purchased outside of a qualified plan. Let us help you to find the money.
We would love to assist you with any financial decision and making sure that you are coordinating it into your overall financial plan.
Tax planning and advice should be reviewed by your personal tax advisor. The staff at Drive Tax and Accounting and Tom Wheelwright, CPA contributed to this article.
One of the tools we are able to utilize when discussing the best course of action to secure your financial future is known as The Personal Economic Model®. Much as a medical doctor would use an anatomical model to convey medical concepts, we use the following model to convey financial concepts.
This model offers a visual representation of the way money flows through your hands. On the left, you will notice the Lifetime Capital Potential tank which illustrates that the amount of money you will control during your lifetime is both large, as well as finite. Once earned your money flows directly to the Tax Filter where the state and federal governments extract tax dollars due from earnings on your monthly cash flow. The after tax balance is then directed to either your Current Lifestyle or your Future Lifestyle determined by your management of the Lifestyle Regulator. Determining the balance of cash flow between your current lifestyle desires and your future lifestyle requirement may be the most important financial decision you will ever make.
Each and every dollar that is allowed to flow through to your Current Lifestyle is consumed and gone forever. The goal is to accumulate enough money in the Savings and Investment tanks so that by the time you retire, the dollars in those tanks can then be used to satisfy your future lifestyle requirements.
Position A would be to have enough in the tanks to live like you live today adjusted for inflation and have your money last at least to your life expectancy. That’s a win, but the icing on the cake would be to accomplish that with little to no impact on your present standard of living, and that is exactly what we strive to help our Members to do.
In working together, we can help you to address the following:
Optimize the balance between your Current and Future Lifestyles
Improve efficiency in your current personal economic model
Design, implement, and execute a plan to secure your financial future
Limit the impact on your Current Lifestyle dollars (maintain your current standard of living)